For good reason, companies
and their boards are searching for bragging rights to good, better or best
corporate governance practices. The notorious accounting failures that led
to the passage of the Sarbanes-Oxley Act and Securities and Exchange Commission
(SEC) and stock exchange rulemakings have left directors, executives, their
lawyers and accountants scrambling during the past two years to implement
or improve processes and procedures which comply with the new mandates regarding
disclosure, governance and accounting procedures. At the same time, media
and investor interest in corporate governance issues has increased dramatically,
and reports of corporate governance weakness and related issues are routinely
in the news. Once-passive institutional and retail shareholders are now flexing
their muscles and achieving impressive successes on shareholder ballots.
There is also an increasing amount of empirical data to support the position
that better governance correlates to better shareholder value.

This increasing focus on governance has also resulted in
a proliferation of published rating systems that rank on an absolute basis,
and analyse and compare the relative corporate governance practices of public
companies. With these developments, directors should address the implications
of the ratings programmes and the criteria they use.

Why should directors and executives care about
corporate governance ratings?

Bad press

Given the widespread media focus on corporate governance
recently, it is clear that bad ratings can make good press. Ratings are now
being widely published, including being licensed by investment firms and
published with their analyst reports. Directors may also be concerned that
inferior governance ratings for companies with which they are associated
reflect adversely on the quality of the boards on which they serve.

Empirical data

Additionally, although still too early to be certain,
there is increasing empirical evidence that good governance correlates with
increased shareholder value and particularly bad governance is a red flag
for increased risk. Such evidence includes recent studies jointly sponsored
by ratings services to support the proposition that ratings are a valuable
investment management tool. Interestingly, one rating service, GovernanceMetrics
International (GMI), noted that it red-flagged Parmalat in July 2003, months
before its implosion. The following studies published recently and in the
last couple of years support the simple proposition that greater shareholder
governance translates into greater shareholder value over time:

• A
study by Rutgers University professors Joseph Biasi and Douglas Kruse examining
stock option grants and shareholder returns at the 1,500 largest US companies
from 1992 to 2001 revealed that companies dispensing significantly larger-than-average
stock option grants to their top
five executives produced lower total returns
to shareholders over the period than those dispensing fewer options;

• A
joint study undertaken by Institutional Shareholder Services (ISS) and
Lawrence Brown and Marcus Taylor of Georgia State University showed a correlation
between corporate governance practices and company performance;

• A
March 2004 study by GMI also found strong correlations between formidable
governance practices and higher average annual total returns; and

• Standard & Poor’s
(S&P) wrote in an October 2002 article that the linkages between credit
quality and corporate governance can be extensive, with weak corporate
governance potentially undermining creditworthiness in several ways, and
should serve as a red flag to credit analysts.

Shareholder activism

Further, whether or not there is a supportable empirical
relationship between corporate governance ratings and investment returns,
directors who remain insensitive to the current shareholder governance climate
will not withstand the veritable tsunami
of shareholder activism that is rolling through stockholder annual meetings.
Shareholder resolutions are achieving unprecedented success and boards of
directors are listening. For example, as of early March 2004, a dozen companies
had taken steps to dismantle their poison pills, compared with just 29 for
all of 2003 and just 18 in 2002. The much publicised campaign against Michael
Eisner at the Walt Disney Company resulted in 43 per cent of the shareholders
withholding their vote for his re-election, and the Disney board deciding
to separate his duties as chief executive officer (CEO) and chairman and
appoint a new chairman. At the 2003 annual meeting of Hewlett Packard, shareholders
approved by a majority a shareholder proposal requesting the board to require
future shareholder approval of any new grants of executive severance that
exceeded 2.99 per cent of current compensation or adoption of a poison pill.
Following this vote in July 2003, the Hewlett Packard board adopted new policies
that were responsive to these proposals. At the 2003 shareholder meeting
of General Electric – a company that has over 10 billion shares outstanding,
43 per cent with retail holders – the shareholders narrowly missed a majority
vote and received 48 per cent approval of proposals similar to those passed
at Hewlett Packard.

The 2004 proxy season also is witnessing an unprecedented
campaign by CalPERS (the California Public Employees Retirement System),
the largest public pension plan in the United
States, to withhold votes for directors who
flunk its strict and rigid independence and
voting strictures. The campaign resulted in the unbelievable vote by CalPERS
against retention
of legendary businessman Warren Buffett as a director of Coca Cola because,
in his role as a Coke audit committee member, he authorised Coke’s independent
accounting firm to perform non-audit services in violation of CalPERS policies.

New regulations favouring shareholder governance

Regulatory rulemaking in support of greater shareholder
governance continues to build with increased focus on greater shareholder
voting rights. This past year saw new requirements that ‘street-name’ nominees
can no longer vote on equity compensation plans and must pass through those
votes to the actual beneficial shareholders. Since the end of June 2003,
mutual funds have been required to disclose publicly their voting policies
and voting records. The SEC also continues to review its proposal to provide
significant shareholders with access to company proxy materials to nominate
a director where shareholders previously received shareholder approval for
a proposal which was not acted on by the company.

For all these reasons, whether board members believe that
governance ratings are a meaningful or fair indication of the board’s performance
or not, they cannot turn a blind eye to the consequence of their governance
ratings.

The firms that provide direct ratings are
as follows:

• GMI, which designed
its rating system in
April 2000;

• ISS,
which in June 2002 established its Corporate Governance Quotient rating
system;

• S&P’s
Corporate Governance Services Department, which made its Corporate Governance
Score service available in July 2002;

• the
Corporate Library, which devised its Board Analyst rating service in December
2002;

• TrueCourse,
Inc, whose SharkRepellent.net provides subscribers with a tool to assess
the defensive characteristics of specific companies; and

• Moody’s
Investors Service, which provides corporate governance assessments as part
of its corporate finance research product.

In late February 2004 ISS and FTSE Group announced that
they are collaborating to create new global corporate governance indices.
The new indices are scheduled to be available in the second half of 2004.
FTSE Group creates and manages financial indices for investors and exchanges
across the world. The new ratings will be designed to compare companies within
global portfolios using a single index. ISS and FTSE launched an extensive
survey project in late May 2004 to assess the marketplace for corporate governance
measurement tools.

This chapter addresses the ISS metric, the
GMI metric, the S&P scoring system as described
in the white paper, and the Corporate Library Board Analyst service. By reviewing
the governance criteria being examined, a company should be able to assess
the strengths and weaknesses of its own governance practices and potential
ways to improve its ratings.

ISS

ISS has historically provided research and advisory services
to assist institutional investors in evaluating voting on proxy proposals.
ISS develops policy guidelines and proxy analyses, provides consulting services
to clients who vote proxies and offers voting agent services. ISS has sought
to leverage its impressive customer base in the proxy advisory business into
a new product offering, the Corporate Governance Quotient. The Corporate
Governance Quotient rating appears on the front page of each ISS proxy analysis,
along with information providing context for the rating. A table on the second
page of the ISS proxy analysis provides details of the key factors that drive
the rating. ProxyMaster.com, ISS’s electronic platform for delivering research
to institutional investors, allows its users to screen portfolio companies
on the basis of their Corporate Governance Quotient ratings. Additionally,
Salomon Smith Barney, Goldman Sachs, Dow Jones, Fitch Ratings and Prudential,
among others, have purchased access
to the Corporate Governance Quotient database and include this data in their
research reports. ISS charges the companies it rates for access to a matrix
that provides subscribers with visibility to their Corporate Governance Quotient
based on their chosen answers to the standardised questions.

Corporate Governance Quotient rating

The ISS Corporate Governance Quotient ratings are relative
and are reported on a percentile basis ranging from zero to 100 per cent.
A company’s Corporate Governance Quotient rating will appear on the first
page of each ISS proxy analysis. Each company receives two ratings. The first
score compares the company’s corporate governance practices against a relevant
index – the S&P 500, the S&P (mid-cap) 400, the S&P (small-cap)
600 or the remainder of the Russell 3000.

The second score compares the company’s corporate governance
practices against its industry peers using S&P’s 23 sector groupings.

The ratings comprise eight core topics:

• board structure and
composition;

• charter
and bylaw provisions;

• audit
issues;

• anti-takeover
practices;

• executive
and director compensation;

• progressive
practices such as board performance review;

• director
and officer stock ownership; and

• director education.

The core topics currently have 61 ratings variables which
determine the total Corporate Governance Quotient score.

Data gathering

ISS gathers the majority of the data for the Corporate
Governance Quotient rating from publicly available disclosure documents such
as proxy statements, annual reports and prospectuses, press releases and
corporate websites. Companies may also:

• visit the Corporate
Governance Quotient
website at any time to review the list of ratings
criteria and submit to ISS, at no charge, changes or corrections to their
corporate governance profile; and

• subscribe
to a fee-based subscription service
that allows companies to learn how to improve their ratings and to benchmark
their corporate governance practices against a self-selected
peer group.

Corporate Governance Quotient subscription service

Companies that do not subscribe to the ISS Corporate
Governance Quotient service will not know their rating until it is released
by ISS. Non-subscriber companies will not be able to preview their ratings
among the governance variables and will not be able to view their Corporate
Governance Quotient rating as compared with peer companies and the indexes.
The current annual subscription fees range from US$10,777 to US$18,444, depending
on the company’s market capitalisation. The annual subscription runs until
the company’s next annual stockholders’ meeting. ISS has been criticised
for providing the Corporate Governance Quotient on the initial ISS proxy
analysis but only allowing subscribing companies to optimise their rating
through trial and error utilising the ISS materials.

Contact ISS

Companies should consider subscribing to the Corporate
Governance Quotient rating service for at least one year to maximise their
potential rating. Although the ratings are computed relative to peer companies,
after the first year of subscription to the service it may not be possible
materially to increase a company’s rating. Since there is no fee or subscription
required, public companies should annually submit their corporate governance
data points to ISS
for comparison to the internally generated ISS information and resolve any
discrepancies.

S&P

Known traditionally for its credit and debt
ratings of large-cap companies, S&P also offers the S&P Corporate
Governance Scoring Service. S&P approaches the governance rating with
a process more similar to its debt rating than the mechanistic approach of
some of the other governance ratings, and benchmarks governance practices
to corporate governance standards on a global basis.

S&P’s governance services website is found at www.governance.standardandpoors.com.

In July 2003, S&P’s Governance Services Department
published a follow-up to its July 2002 white paper which described S&P’s
Corporate Governance Score criteria and methodology. What follows is an overview
of the July 2003 white paper.

Core principles

S&P’s Business Sector Advisory Group on Corporate
Governance to the Organisation for Economic Cooperation and Development has
articulated a
set of core principles of corporate governance practices: fairness, transparency,
accountability and responsibility. S&P uses these principles as the basis
of its corporate governance scoring methodology
for individual companies, and emphasises that this methodology can be used
to analyse governance
at both a country and a company level.

Process and structure of Corporate Governance Score

S&P’s Corporate Governance Score assesses a company’s
corporate governance practices and policies and the extent to which these
serve the interests of the company’s financial stakeholders, with a particular
emphasis on shareholders’ interests. The creation of the Corporate Governance
Score encompasses the interactions between a company’s management, its board
of directors, shareholders and creditors.

Typically, analysts from S&P’s Corporate Governance
Services and S&P’s affiliates, local
law firms and other professionals in corporate governance, as appropriate,
will conduct interviews for the company being evaluated. This committee will
also inspect company documentation, including its public filings, regulatory
filings, internal governance records such as board and board committee minutes,
and legal compliance records. Typical interviewees include the CEO, finance
director, corporate counsel/company secretary, board of directors (in particular
the chairman and independent directors), shareholder relations personnel,
key shareholders and creditors, and the company’s auditor.

The Corporate Governance Score is assigned
on a scale from one (lowest) to 10 (highest).
A score of zero will be awarded where a company
is unable or unwilling to provide enough information for a meaningful analysis.
Additionally, scores from one to 10 are awarded to the four individual components
that contribute to the overall Corporate Governance Score. These components
are:

• ownership structure
and external influences;

• shareholder
rights and stakeholder relations;

• transparency,
disclosure and audit; and

• board
structure and effectiveness.

Company report format

Following the company meeting, the committee will prepare
a detailed report covering the main elements of the analysis and will also
articulate the Corporate Governance Score and individual scores for each
of the four components.

Costs

The entire Corporate Governance Score service ranges
from US$75,000 to US$200,000.

GMI

GMI is a company formed in April 2000
which has designed a rating system that
creates a metric to compare companies’ corporate governance characteristics.
The GMI rating system incorporates more than 450 data points across the following
categories:

• board accountability;

• financial
disclosure and internal controls;

• executive
compensation;

• market
for control and ownership base;

• reputational
and socially responsible investment issues;

• corporate
behaviour; and

• shareholder
rights.

Methodology

The GMI rating criteria are based on securities regulations,
stock exchange listing requirements, and various corporate governance codes
and principles disseminated by the various governance authorities and reports.
According to GMI, this produces a set of 450-plus metrics structured in a
manner that can only produce ‘yes’, ‘no’ or ‘not disclosed’ answers, and
therefore designed to be as objective as possible.

GMI’s research process begins with a review of pertinent
public data, including regulatory filings, company websites, news services,
other specialised websites and the Dow Jones Global Industry Classification
System. The collected data is entered into a relational database and the
data entry reports are then sent to each company in the GMI ‘universe’ for
a final accuracy check. After company adjustments are made, the GMI data
is set and GMI then runs a scoring model which calculates the ratings. Companies
are scored on a scale of one (lowest) to 10 (highest). GMI scores are relative
and each company is scored against the GMI universe of companies measured,
as well as against all those in the same country of domicile. Companies
are initially assigned 14 ratings in all. The first are GMI global ratings,
which include an overall GMI score and separate scores for each of GMI’s
six research categories. Global ratings are relative to the 2,100 companies
in GMI’s research universe, which includes companies in the Russell 1000,
S&P 500, S&P Mid-cap 400, TSX (Toronto Stock Exchange Index) 60,
and Nikkei 225 indexes, among others. Each company also receives home market
ratings that reflect how well its governance policies compare to others in
its home country or region.

Scoring algorithm

GMI ratings are generated by its proprietary scoring
algorithm. The GMI research template is divided into six broad categories
of analysis. These categories are further divided into subsections. Each
individual metric has a numerical value, and each subsection and research
category is weighted according to investor interest. GMI’s system utilises
asymmetric geometric scoring, which in effect magnifies the record of ‘outliers’.
These include both those with the very best practices, which are then rewarded
more, and those with the worst, which are penalised.

Company updates and the GMI rating cycle

GMI plans to re-rate all companies in its universe approximately
every six months once it establishes a baseline global universe. In between
these rating runs, GMI monitors each company in its research universe on
a daily basis and will post company updates in order to keep subscribers
apprised of new governance developments at the companies covered by GMI.

If a company has gone through a major restructuring or
governance overhaul in between these planned rating runs, GMI will consider
updating the company’s profile and rating it as a one-off.

Costs

Annual subscriptions for GMI’s North American research
universe start at US$18,000, while annual subscriptions for GMI’s market
sector research
start at US$7,500. GMI indicates that the majority
of subscribers are institutional investors. GMI does not charge rated companies
for its service.

The Corporate Library

The Corporate Library was founded in 1999 by Nell Minnow
and Robert AG Monks, co-founders of ISS. It focuses on corporate governance
and the relationship between company management, their boards and shareholders.

Recently, the Corporate Library developed Board Analyst,
a system for rating board effectiveness, which provides general coverage
of over 2,000 US companies. Available data to Board Analyst Pro subscribers
includes a review of each company’s CEO compensation policies and practices,
and individual director information. Board Analyst Pro also allows for comparison
of the company performance of multiple directorships for each individual
director, and screening for multiple audit, compensation or nomination committee
appointments. Board Analyst Pro is a subscription service which ranges in
price from US$4,000 to US$25,000, depending on the number of users and add-ons.
The Corporate Library does not accept fees from companies it covers.

A simpler level of access to a subset of the
same data is available through the Board Analyst Basic service for US$1,200
per year. A free subscription service is also available and provides the
same level of access as the Board Analyst Basic service, except that searches
are limited to S&P 500 companies only.

In addition, the Corporate Library has devised a proprietary
system for rating board effectiveness, which it believes is an important
indicator of potential investment risk. The rating system is comprised of
five key areas:

• CEO compensation;

• outside
director shareholdings;

• board
structure and make-up;

• accounting
and audit oversight; and

• board decision making.

The board effectiveness rating is not industry based, but
the Corporate Library does group certain companies into special peer groups,
mostly related to their ownership characteristics. Individual scores in each
area are combined to provide an overall board effectiveness rating for each
board. The Corporate Library states in its marketing materials that if it
is “given two firms with similar earnings and commercial prospects, the one
with the stronger board will be the better choice for most investors”.

Criteria

Following this chapter is a comprehensive list of corporate
governance ratings criteria for use in reviewing matters that may affect
your company’s governance rating, and a chart comparing ISS’s criteria with
S&P’s criteria (because GMI uses over 450 different data points in its
analysis, its criteria are not listed).

Management or the board should consider the various criteria
described which affect a governance rating positively or negatively, and
should consider implementing or changing some practices to improve the company’s
rating. Some of these criteria may be easy to improve on because they are
relatively cosmetic and innocuous, and have no practical cost to implement
(eg, adopt and post online appropriate committee charters). Other changes
may be more serious and present fundamental business considerations (eg,
removing poison pills and staggered boards) that should not be made simply
to improve ratings. Recognise that the mechanical ratings process may produce
strange results: for example, a company with a controlling shareholder may
nevertheless get positive ratings credit for the absence of a poison pill
or staggered board – neither of which is a necessary defensive measure where
there is a controlling shareholder. Also, the purely mechanical ratings by
design give no subjective assessment of the quality of management or the
board. Warren Buffet and Berkshire Hathaway best prove this point, with Berkshire
Hathaway having received an ‘A’ rating from the Corporate Library, but a
rating of only 1.5 per cent from ISS.

What to do?

The following are simple measures that directors and
executives should require that their company take to improve its governance
rating:

• Actively review ratings
and correct inaccuracies;

• Discuss
and negotiate issues with rating services;

• Post
committee charters, policies and codes of conduct on the company website;

• Monitor
current hot topics such as non-audit services, diversity, executive severance
and staggered boards; and

If the company does not experience a
material increase in its corporate governance ratings after having implemented
some or all
of these recommendations, directors and executives should consider purchasing
a subscription
service or ratings ‘consulting’ from ISS and other rating services.

Conclusion

It is unclear how important corporate governance ratings
will ultimately be to investors. Indeed, the utility of such ratings is weakened
by the apparent lack of consistency between rating services. To the extent
ratings are relative, they will also become less important over time as practices
generally improve and the bar is uniformly raised. Many large institutional
investors have their own programmes for measuring governance and will not
rely on a service to measure these issues.
Others simply do not think these ratings are relevant to investment decisions
about the quality of a company or its management. Nevertheless, both investors
and issuers may find it increasingly difficult to avoid the implications
of governance ratings which may be viewed as a proxy to a company’s regard
for its shareholders.

Special thanks go to Aaron Vantetson, an associate in the Corporate Department
of Katten Muchin Zavis Rosenman.